Average Private-Equity Investor Merely Breaks Even, Study Claims

By Brendan Conway

Private-equity investors often enjoy superior returns. But what happens when you account for factors like illiquidity and high fees — both of which make it riskier to invest?

Three academics argue in a new National Bureau of Economic Research paper private equity is basically a wash for the average investor, once you price in the various risks — such as being locked in for years, or not being able to rebalance the portfolio as the years go by.

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“On average, LPs may just break even, net of management fees, carry, risk, and costs of illiquidity,” write Morten Sorensen of Columbia University, Jinqiang Yang of Shanghai University of Finance and Economics, and Neng Wang of Columbia Business School. “LP” is limited partner, which is the lingo for the high net-worth individuals and institutions who invest in private equity.

Here’s a look at the intuition:

PE investments are illiquid and long term. PE funds have ten-year maturities and the secondary market for PE positions is opaque, making it difficult for LPs to rebalance their PE investments. Second, PE investments are risky. Part of this risk is spanned by publicly-traded liquid assets and hence commands the standard risk premium for systematic risk. The remaining part of this risk, however, is not spanned by the market, due to illiquidity, and the LP requires an additional premium for holding this risk. Third, the management of the PE fund is delegated to a general partner (GP), who receives both an annual management fee, typically 1.5%{2% of the committed capital, and a performance-based incentive fee (carried interest), typically 20% of prots. Intuitively, management fees resemble a fixed-income stream and the carried interest resembles a call option on the fund’s underlying portfolio companies. Fourth, to compensate the LP for bearing the unspanned risk as well as management and performance fees, the GP must generate sufficient risk-adjusted excess return (alpha) by effectively managing the fund’s assets.

Meanwhile, shares in Blackstone Group (BX) and Fortress Investments (FIG), two stocks with PE exposure, are ahead by 67% and 77% during 2013, and you don’t need to be an “LP” to buy those.

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